The politics of debt – why overcoming structural deficits might be both easier and more difficult than generally assumed
July 8, 2013 Leave a comment
Over the past few years, it seems that politicians have suffered an important loss of independence. Instead of displaying leadership and shaping economic policy, they are being chased by “the markets”. Central banks around the world have heeded politicians’ calls for help and reduced interest rates to historic lows. Nevertheless, growth remains slow, unemployment high, and investors nervous.
Not least in Europe, governments and the European Central Bank (ECB) outbid each other in their efforts to contain market fears and return the common currency to stability. It took no less than Mario Draghi’s announcement of the ECB’s “Outright Monetary Transactions Program”—the ECB’s commitment to buy unlimited government bonds on the secondary market—to break the vicious circle of spiraling government debt and bank rescues. Investor fears remain, however: Cyprus’ bailout in March this year warrants further caution on this front and when the Federal Reserve recently hinted at a possible end of Quantitative Easing next year, stock markets fell.
The reasoning underlying loose monetary policy in the current crisis is based on solid economic theory and most economists agree—at least in principle—that this approach is right. Similarly, all rescue measures following the initial Greek bailout certainly prevented a dangerous domino-effect. However, government bail-out packages in the Euro area, central bank bond-buying programs, and low interest rates share a common feature: they merely deal with problems in the short-term.
At first, this does not seem like a revolutionary statement—most economists will reply that monetary policy obviously only affects the short run and politicians will maintain that they are well aware of the need for structural reform. After all, long-term reforms require time to take effect; loose monetary policy, bailout and bond-buying programs are therefore dictated by current circumstances without leaving much room for alternatives. To a certain extent, this is true and in this sense, politicians and central bankers are merely reacting to the crisis. However, this story suffers from two oversimplifications.
First, it neglects the effect of short-term relief on politicians’ incentives to tackle long-term problems. Decision-makers have to strike a balance between the costs of reform and the costs of inactivity. On the one hand, implementing painful budget cuts and structural reforms that lower real wages and pension benefits creates discontent and therefore cost governments their popularity and votes. On the other hand, the immediate crisis results in political pressure that requires a reaction and the provision of solutions by politicians. By nudging central banks to loosen monetary policy and providing short-term relief in the form of rescue-packages, governments can avoid costly structural reforms while displaying activity and reducing popular pressure. The result is that—although economically sound—short-term relief might actually harm the process of necessary long-term structural reforms by reducing politicians’ incentives to implement it.
Second, the story ignores the immediate positive effects that the adoption of long-term reform measures can have. The reason why the Eurozone had to adopt several subsequent ultima ratio rescue packages is that the governments never provided a credible roadmap for sustainable reform of their public finances. Similarly, postponing decisions about the public pension reforms and other demographic challenges creates uncertainty in the business environment which severely reduces private investment.
The point here is that the way out of the current economic crisis lies in the adoption of both short-term and long-term measures. The rationale should be that a real solution is the adoption of structural reforms and the reduction of structural budget deficits. A simultaneous loosening of monetary policy together with emergency provisions for the stabilization of the financial sector are equally important, but they merely buy time for the former to take effect. While a tendency to myopic economic policy represents a systemic difficulty of any democratic system, more weight should therefore be placed on the benefits of reducing political window-dressing and increasing transparency and accountability in economic policy-making. If politicians stop blaming the markets for being suspicious of their policies, they can co-opt them and thereby regain control of the situation.
By: Marvin Gouraud
Sources: European Central Bank, Journal of Economic Policy Reform, The Economic Journal, Critical Review, The Wall Street Journal, Journal of Public Policy, Capital Markets Law Journal, Business Week, Council of the European Union, The International Spectator